Hedging - Short Hedging and Long Hedging

Of the 120 questions on the Series 3 exam, you can expect around 10 on basic hedging, calculating the basis and hedging futures.

Short Hedging and Long HedgingTo hedge is to protect. A hedge is a position taken to reduce a risk. The hedger may or may not actually own the commodity associated with a given risk and makes the purchase or sale of the futures contract to substitute for an eventual cash transaction. Perhaps an investor has a future need for a commodity or expects to enter the market for that commodity at a later date. If so, she has, in effect, a current position in it and may have a need to mitigate the risk that its price will move against expectations.

Anticipatory HedgesAn "anticipatory hedge" is a contract purchased in anticipation of needing a commodity at a later date. This approach is used to protect against a price increase by fixing a future purchase price.

For example, let's say that a trader represents a company that manufactures plumbing and electrical supplies. His client needs a steady flow of copper as a raw material. To keep the math simple, let's suppose the client needs 100,000 lbs. of copper in two months. Let's also suppose the client does not have adequate storage facilities to keep more than one month's inventory on hand, so buying copper on the spot market and storing it until needed is not cost-effective. It is late August and the current spot price is quoted as 350 cents/lb., which the client considers a bargain; the OCT future price is 400 cents/lb., which is the figure the client knows is still profitable, and the DEC price is 450 cents/lb., which is far too expensive. This DEC price makes the trader want to lock in at 400 cents/lb. in case the expected price increases prove to be more rapid than the market currently anticipates.

So the trader enters into an anticipatory hedge by buying four 25,000-lb. OCT copper futures contracts on the New York Mercantile Exchange's Comex division, at $400/lb. This costs his client a total of $400,000 to meet the expected need of 100,000 lbs. of copper in October.

Suppose that, when the October delivery date comes around, the spot price for copper is 410 cents/lb. The trader buys copper on the spot market for $410,000. Because the spot and OCT futures price will be identical on that day, the trader sells the contracts for 410 cents/lb., or $410,000.

He paid $10,000 more than he wanted to for the copper, but sold the futures contracts for $10,000 more than he assumed they were worth when he bought them.

In a perfectly efficient and transparent market, wealth is neither created nor destroyed in an anticipatory hedge. However, no hedge is air tight as the following discussion on basis will attest.

BasisThe foregoing example oversimplifies for the purpose of illustration. If the futures markets failed to create, or at least transfer, wealth, there would be no purpose to them. In the real world, there is a difference between the cash price and the future price, referred to as "the basis." Candidates should not confuse this definition with the accounting concept of basis which refers to the price that one pays for an asset along with adjustments to it, depending upon the facts and circumstances of the purchase.

Basis is the price difference between a commodity's local cash price and the price of a specific futures contract of the very same commodity. When basis is negative, it is due to the cost of carrying the commodity (the cost of carry).

In a normal or contango market, the actual price of the commodity will be lower than that of its futures price.

In an inverted or backwardation market, the futures price is higher than the price of the actual commodity (referred to as the ‘actuals'.)

Formula 6.1Current (local) cash price – futures price = the basis

The trader in the anticipatory hedge example above was "long the basis," that is, he bought the commodity and hedged with a sale of futures contracts. His counterparty was "short the basis," that is, she bought the futures as a hedge against a commitment to sell in the cash market.